In Shakespeare's play Hamlet, Polonius (Lord Chamberlain to the King of Denmark) offers his son, Laertes, advice as the latter embarks on a journey to continue his education. Among the oft quoted admonitions is the injunction, "Neither a borrower nor a lender be". Polonius' advice is of an age and time long past, spoken long before the emergence of financial intermediaries who are simultaneously both borrowers and lenders of credit.
Indeed, one man's loan is another man's asset. Interest paid as an expense by one generates the income received by another. So while we may forget or elect to ignore Polonius' wisdom, we cannot escape the bounds imposed by double entry bookkeeping. A simple concept but an idea we have difficulty grasping when we debate as a society debt and its necessity. In the United States today there is much hand-wringing and lamentations over the past decade's debt binge. The debate is emotional — often with more heat injected into the conversation than light shed by sound analysis.
A number of commentators continue to use the ratio of credit market debt to nominal gross domestic product (GDP) to make their case against profligacy. The problem is the gross credit market debt number compiled by the Federal Reserve (in its quarterly Flow of Funds Accounts of the United States) double counts debt issued to purchase other debt. When this distortion is removed, we estimate net debt as a percentage of GDP at 156 percent (at the end of the 1st Quarter 2012) instead of the naïve 353 percent obtained by dividing the raw, unadjusted debt by GDP.
True, however, one computes it the trend is the same. Yes but the magnitudes are off by a factor of two, distorting the debate. What has wrought this change, producing such a discrepancy? It one word, it is technology. Advances in communications and computers have steadily reduced the costs of originating a loan or executing a trade. Consequently the "flora and fauna" of the financial market eco-system has grown more diverse. Forty years ago, banks, life insurance companies and retirement plans dominated. Today to that list we can add asset-backed and mortgage-backed issuers, funding companies, government sponsored enterprises (Fannie Mae and Freddie Mac) and mutual funds issuing, buying and selling new types of securities that were unimagined in the 1970s. This evolution has enabled more parties in the debt markets to co-exist between the spread dictated by the ultimate cost to the end borrower and lowest cost of funds obtainable by a lender.
In particular, the emergence and growth of mortgage-backed (MBS), and, later on, asset-backed (ABS), securities widened this spread between adjusted and unadjusted debt levels. A home mortgage originated by a commercial bank is now routinely bundled and sold through the agency of a government sponsored enterprise such as Fannie Mae. In an instant one dollar of debt (the original mortgage) becomes two (the mortgage and the newly minted MBS bond). Downstream an investment bank may create a funding company to purchase the MBS bonds and engineer the cash flows or credit exposure to create a CMO (collateralized mortgage obligation) or a CDO (collateralized debt obligation). The original one dollar of mortgage debt still exists but it now supports a $1.25, say, in bonds. Now when you adjust — offsetting the debts and assets of the major financial entities — only one dollar remains. Forty or fifty years ago such multiplication was impossible.
The near collapse of the MBS and ABS markets explains why unadjusted total indebtedness has fallen from 382 to 353 percent since 2009. The debts remain but now with fewer links in the chain. Despite the chain tightening, regulators must enhance transparency. Each link increases the difficulty of confidently valuing the end underlying assets. Accurate and timely pricing helps. But the greatest need is for quality ratings and analysis, free conflicts of interest, which investors can implicitly trust.
The analysis is based on data obtained from the Federal Reserve Board's (FRB) Flow of Funds Accounts for the United States (FoF) report dated June 10th, 2012.
Nominal gross domestic product (GDP) was obtained from the Bureau of Economic Analysis (BEA). GDP is a widely used measure of the total goods and services produced (consumed) by a nation over a period of time. Nominal GDP reflects the value of the aggregate goods and services at current price levels.
We undertook our analysis by exploding the underlying tables to the L.1 and L.4 Tables in the FoF. In addition, to the debt instruments included in those tables, we also factored in Certificate of Deposits and Savings Account data since these are a primary source of funding for banks and credit unions. The first step was to create a summarized balance sheet for each major entity (viz., households, the federal government, domestic chartered banks, asset –backed security issuers, etc.). The next step was to assume each sector retired all or a portion of its debts by using whatever financial assets it possessed to repay its obligations. Then the net remaining indebtedness across all sectors was computed. We call this result is the adjusted net indebtedness for the United States.
(Sources: FRB; BEA; AIFS estimates.)
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